Europe finally acquires the US’s appetite for ETPs

Industry growth started at a snail’s pace in the US but has gained incredible momentum to become an industry with trillions of dollars of assets under management (AUM).

In spite of the European ETF market being much smaller in AUM terms than the US, the changes to the European ETP market are likely to be far more dramatic in the near term.

The structural changes in the ETP market are largely being driven by investors’ perceptions that ‘physical’ replication is preferable to ‘synthetic’ replication through swaps.

With physical replication, the view is that investors ‘own an asset’, but that with swaps they ‘own bank risk’ – an argument banks have clearly lost. In reality both methods have their advantages and whichever technique is used, ETP structures are arguably more robust than mutual funds.

Given the increasing preference for physical replication, ‘core’ products will gravitate in that direction, with synthetic replication filling in the gaps where physical either can’t be used or is not efficient.

With well-thought-out and appropriate collateral arrangements for counterparty protection, synthetics are generally accepted by investors for this supporting role. Indeed, synthetics are increasingly used for innovative investment strategies and to improve tracking efficiency.

The battleground for the next five years and beyond will be among the top five or six providers fighting to break BlackRock’s European dominance, particularly in the ‘core’ range offerings. The provider making the running here is Vanguard.

The fight is likely to intensify and mirror the story in the US, with Vanguard’s low-cost approach increasingly difficult for BlackRock and others to compete against in the provision of plain vanilla ETFs. Fees are dropping as a result of this competition and investors are the ones to benefit.

The second major structural change will be regulators moving towards requiring investment bank providers to accept the majority, if not all, of their swaps from third parties.

Preventing ETPs from using swaps would be throwing the baby out with the bath water, especially where physical doesn’t work or isn’t efficient. However, ensuring that providers get their swaps from a third party and therefore not concentrating their risk within the same company does seem sensible.

For the investor, this new model means a provider can change counterparties at any point if it is in the best interests of investors and that such decisions become independent of any conflicts of interest.

The main battleground for innovation is, and will be, what is lazily coined the ‘smart beta’ space.

‘Smart beta’ is a catch-all term for all index methodologies other than market capitalisation, which invites the criticism that it overweights overvalued stocks and underweights future value.

It is already clear ‘smart beta’ is where the main area of innovation is going to be focused on by providers. Particular success has been evident for dividend, earnings, equally-weighted and minimum-variance index strategies.

This year and beyond will see the European ETP market continue to grow rapidly, structurally change and increase innovation. It’s safe to say the US is still leading the way, but Europe is learning and catching up fast.

Hector McNeil is co-chief executive at Wisdom Tree Europe

ETF industry: in numbers

The ETF industry is challenging the supremacy of the mutual fund market and is now growing at a considerably faster pace.

By any standards the ETP industry has become a meaningful asset management segment and arguably the most dynamic. The wider mutual fund management industry still dwarfs ETFs with tens of thousands of products available. ETPs, in comparison, account for less than 10 per cent of global assets under management.

The global ETP market has grown to $2.64 trillion at the end of June 2014. This breaks down as follows:

US – $1.86trn

Europe – $470bn

Rest – $250bn

There are currently 5,359 ETFs and ETPs, with 10,401 listings, from 219 providers listed on 59 exchanges.

(Source: ETFGI)